Revised pact will raise euro entry bar

By Stewart Fleming

Date: 09/09/04

SOMETIME next year perhaps, when the new Stability and Growth Pact is nailed down, readers of the final text could usefully remember the words of St Augustine of Hippo: "Give me chastity and continence - but not yet".

The proposals for the new pact, outlined last week by the European Commission, will give prospective rule-breakers plenty of opportunity to postpone the day of judgement.

The strengths of the old pact, agreed in 1997, were its simplicity (the 3% deficit limit and 60% debt to gross domestic product ceiling) and the apparent sharpness of its teeth.

But, as Commission President Romano Prodi remarked last year, in the subtle world of economic policy "simple" turned out to be "stupid". As for the teeth, we know now that the gums holding them were rotten.

If France and Germany, serial infringers of the spirit of the pact, can be absolved from punishment for their misdemeanours, then you can be quite sure that no other eurozone country is ever likely to face being fined for breaching the accord.

No wonder then that last week's Commission paper on reforming the pact emphasized "peer pressure," not financial sanctions, as the first line of attack when it comes to trying to enforce compliance with a new agreement.

But if existing members of the euro-club are unlikely to face the threat of official penalties, the same cannot be said for the new EU members.

The 1997 Stability and Growth Pact had bite, not because of the threat of fines, but because of the threat of exclusion from membership of the single currency. It is no accident that, for many countries, fiscal discipline began to erode once the founding members of the single currency had been chosen.

The new pact, as proposed by the Commission, is going to be much more sophisticated and focus much more on whether countries can manage the burden of their debts, less on the 3% deficit to GDP ratio.

So the simple 60% of GDP debt ceiling is to be refined. Instead, sustainability of debt levels - for example whether the debt ratio is rising or falling and whether prospective state pension liabilities have been taken into account - are going to become a much more important focus of the new pact.

As for the 3% deficit limit, which like the debt ratio is also written into the Maastricht Treaty, flexibility of interpretation will be the watchword here too.

A refined judgement will be made over the extent to which breaches of the pact may arise as a result of budgetary indiscipline or are the result of some external shock or of a yet to be defined, "extended period" of low growth. Kiss goodbye to the current, simplistic "get-out-of jail-free card", namely a 2% or greater fall in GDP.

As a result, demonstrating conclusively that you meet the Maastricht criteria is going to be more difficult. So the potential barriers to entry into the euro-club are, in effect, being raised.

As for the existing members, let's face it, the world has changed since 1997. Then rapid growth was presumed to be a cyclical fact of life. Today, nobody can be sure whether the EU's trend growth rate is going to be its historic 2% or much less.

The current anaemic EU expansion could falter, or worse, be undermined again by the recession now looming on the horizon in the United States as consumer spending there slows but scope for further fiscal or monetary stimulation is exhausted.

In the short term, it is not euroland's budget deficit of around 2% of GDP, but America's twin budget and current account deficits of close to 5% of GDP, which are the real threat to Europe's (and the world's) economic stability. The old Stability and Growth Pact may have been buried in the nick of time. Right now, the more flexibility the better, so far as EU economic policy is concerned.

Longer term, European Central Bank (ECB) President Jean-Claude Trichet is right to be worried about the way reforming the pact could tend to undermine fiscal discipline in Europe and make his job much harder.

But, on this score, it would be a mistake to overlook other changes that have taken place since 1997 when the pact was born.

The pressures for fiscal rectitude have strengthened since 1997. The ECB now exists as a credible and uniquely powerful central bank and a bulwark against fiscal indiscipline. The euro-group of 12 eurozone finance ministers and a few top Commission and ECB representatives has emerged as an intimate, and therefore powerful, economic policy forum where peer pressure can really make a difference.

And Europe's policymakers have recognized now that they, and Europe's corporations, have their backs to the wall. They know just how big an economic (and strategic) challenge the rise of China represents and how potentially unstable a financial market-driven global economy can be.

The old Stability and Growth Pact has served its purpose, what is replacing it is more complex but it is likely to be much more useful.

• Stewart Fleming is a former US editor of Financial Times and now a freelance journalist in Brussels.

Author discusses the effects of the revision of the Stability and Growth Pact towards more complex regulations.